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Basel watchdogs back Canada's banking scheme

OTTAWA • Canada’s push to have bank debt converted into equity in the event of a government rescue has won over global banking regulators, who on Thursday said it could be part of a suite of financial reforms up for approval by Group of 20 leaders at their summit in November.

The so-called Basel Committee on Banking Supervision endorsed the idea of embedded contingent capital in documents published Thursday, and asked stakeholders to comment on its possible implementation by Oct. 1.

Under contingent capital, banks would insure themselves against failure through the issue of debt that could be converted into equity at the time of any possible failure. The conversion would occur at the behest of federal authorities, on the belief the company cannot be saved without government intervention. The underlying idea is that bank equity and debt holders have an added incentive to monitor lending practices.

The Basel Committee concurred, and is prepared to include the idea in its list of banking reforms that G20 leaders will be asked to endorse at a summit in Seoul.

“The increased downside risk will provide an incentive for the investors in capital instruments to monitor the risks taken by the issuing bank,” said the committee, which represents central banks and regulators in 27 countries and sets capital standards for banks worldwide. “If a bank takes more risk, and the risk of loss to investors increases, buyers of existing instruments … will demand a higher coupon. This sequence of events should help impose additional market discipline on banks.”

Federal Finance Minister Jim Flaherty said on Thursday he was “pleased” the Basel Committee was prepared to head Canada’s advice.

“Canada continues to play a lead role in focusing financial reform discussion on the core issues of quality, and quantity of capital,” Mr. Flaherty said.

Julie Dickson, head of Canada’s banking watchdog, the Office of the Superintendent of Financial Institutions, pitched this idea in an April piece for the Financial Times as Canada and Europe were locked in a fierce debate over the merits of a global bank tax.

Canada vehemently argued against the levy, saying its lenders shouldn’t be punished as they were not responsible for sparking the credit crisis.

Contingent capital was put forward as an alternative for G20 countries to consider — and that happened, as G20 members eventually cooled to the idea of a levy. At the G20 leaders summit in Toronto in June, it was agreed individual countries could pursue a bank levy is they desired but no global levy would be pursued.

In its paper, the Basel Committee said the scheme should help in reducing moral hazard, or the implicit belief risky bank lending can proceed because governments are prepared to backstop lenders should they backfire. The Basel Committee said moral hazard “is seen by some as an underlying cause of the current financial crisis and a potential cause of future crises.” (Mark Carney, the Bank of Canada governor and chairman of a key global committee of central bankers, has repeatedly warned the global economy remains “awash” in moral hazard.)

News of the Basel Committee’s endorsement drew concerns from some banking observers. Regulators are proposing an “instrument that’s very different from what we have now and there’s no standard investor base to buy it,” Oliver Judd, an analyst at Aviva Investors, told Bloomberg News. “There needs to be some form of liquid market out there for investors to be willing to buy and that simply doesn’t exist.”

The Canadian Bankers Association raised similar warnings. “We need to carefully consider the cost and marketability of such an instrument, particularly in a smaller market like Canada,” the lobby group said in a statement. “Ultimately what’s important to banks in Canada is ensuring stability in the financial sector and good risk management.”

Canadian banks have roughly $16.5-billion of so-called subordinated and other innovative capital outstanding. If contingent capital is not part of the final banking rules, some observers argue, this could force Canadian banks to raise additional capital to meet new stringent rules governing capital levels and liquidity standards.